For the first time since the financial crisis, the mortgage industry is securitizing newly minted loans to lower-credit borrowers.
As much as this may be heartening to investors willing to take on more risk in search of new and better sources of yield, the thought may be equally frightening to those who associate the practice with loosely underwritten loans that were securitized without regard for borrowers' ability to repay, a key contributor to the downturn.
Neither side of this question has had much to get excited about, though. There are
That may be about to change. The recently enacted qualified residential mortgage rule is designed to assuage a primary concern about the subprime securitizations of the past: the misaligned interests between secondary market buyers and sellers.
The new guidelines require securitizers to retain a stake in all but the safest of residential mortgage-backed securities. If it's effective, lower-credit mortgage securities should be a safer and more profitable game this time around.
The new guidelines strongly parallel those previously established for individual loans under the qualified mortgage rule, meaning not much will change for securities made up of QM loans. But if this reform is effective, and not too constraining, a market for "non-QRM" securities could emerge into a new business opportunity.
Even before QRM took effect, market participants began experimenting with opportunities beyond the scope of the Fannie Mae, Freddie Mac and Ginnie Mae loan programs to develop models to safely originate and securitize subprime mortgages. And at least one of the fledgling subprime securitizers has plans to issue rated bonds under the new regulation's auspices.
Overall, the nonprime securitization market is smaller and slower, and nearly everyone expects it to remain that way in the year ahead, but it's still a source of underserved demand among borrowers and investors that persists.
"The market has not been served at all for seven-plus years and we believe those borrowers didn't disappear," said Tom Hutchens, a senior vice president at Angel Oak Mortgage Solutions, a nonprime wholesale lender. "With a disciplined approach to offering these programs, we can offer them
It's too soon to tell whether QRM will hinder subprime securitizations and other private-label RMBS or help promote their comeback in a safer form. The other risk is that reform won't prove effective and loosely underwritten securitizations could proliferate to the point where their risk becomes systemic again — however, that seems unlikely, given that the market is not only different but a shadow of its former self.
An affiliate of Hutchens' company, Angel Oak Capital Advisors LLC, recently completed its first securitization of recent-origination nonprime whole loans. Angel Oak, one of a few players that entered the market in 2015, hopes to issue rated deals regularly.
Though the word "subprime" originally meant borrowers with lower credit scores, the term came to be associated with a wider range of risky practices, such as making loans with little or no documentation or at high loan-to-value ratios. To avoid this association, the market has shifted to referring to impaired credit as nonprime.
While borrowers with credit risk scores below the 620-660 range generally have been considered subprime credits, most nonprime borrowers' scores have been higher. Nonprime credit might go down as low as 500, but the average credit score is above 660, said Hutchens.
In addition to promising to avoid "layering," or combining, these risks in the same transactions, Angel Oak has had to address a prominent concern about precrisis subprime securitization—the seller's ability to cast off risk without repercussion.
"I think the one thing that really resonated with investors was the alignment of interests," said John Hsu, head of capital markets at Angel Oak Capital Advisors, commenting on its recent new-origination nonprime deal.
No More 'Sell It, and Forget It'
One way Angel Oak reassures investors that it has skin in the game is that the entity selling the securities has owners in common with the ones that originated the loans. "Because we are affiliates, if you knowingly create a bad mortgage, somewhere along the line we're going to answer to the same person,'" Hsu said.
Also, Angel Oak's hedge fund intends to hold a stake that absorbs the first losses from the collateral pool in the company's securitizations, he said.
Skin in the game has a potential downside, as indicated by at least one post-crisis lawsuit that alleged a conflict of interest. But today, any firm that securitizes anything outside of a plain vanilla mortgage doesn't have much of a choice.
'Non-QRM' Market
Currently, QRM is synonymous with the QM definition that gives originators a safe harbor from ability-to-repay, or ATR, requirements.
QM and QRM safe harbors don't directly preclude a low credit score, but higher points, fees and rates define their boundaries.
This means subprime loans, which generally require somewhat higher fees, points and/or rates to offset the increased risk involved in lending to a borrower who's had trouble repaying debts in the past, will probably be securitized in the non-QRM market, said Suzanne Mistretta, a senior director at Fitch.
Other very different products such as prime-credit jumbo interest-only loans, which also fall outside the QM/QRM boundaries, could also be securitized in the non-QRM market. Investor-owned loans are exempt from ATR and risk retention requirements.
Angel Oak's deal is backed by loans that do not meet the definition of QM or QRM primarily because of their points and fees. So its securitizations will not only include loans with ability-to-repay liability that has to be addressed through documentation, but they have to include a vehicle that can retain risk.
These requirements could be a hurdle for players in the securitized nonprime/non-QM market.
"The ATR market is a challenge from the risk retention standpoint," said Bill Shuey, director of securitization at Opus Capital Markets Consultants. That limits origination.
Angel Oak is working on finding a way to issue non-QRM transactions in a compliant manner. "Yes, our goal is to issue more deals. Is there total clarity on what risk retention structure works? No, there's not 100% clarity and we are working through that issue," said Hsu.
There have been at least four non-QM deals done in the past year, according to Carl Bell, managing director and co-head of investment at Invictus Capital Partners.
Invictus has an affiliated correspondent investor that purchases closed non-QM loans. It plans to securitize this year. "We will use securitization as a financing tool and retain 15% or more of the most junior bonds created in a securitization transaction," said Bell.
A Deal Agent Lite
Angel Oak's deal also has an additional mechanism in place that, according to Hsu, protects the rights of all investors in the transaction.
The company hired Clayton Holdings as a representations and warranties administrator. If an underlying mortgage goes 120 days-plus delinquent, it automatically goes to a review process, said Hsu.
If the administrator determines something went wrong during origination, it can recommend the deal sponsor buy the loan out at par to insulate investors from the risk. The sponsor can argue the point and in the event of a dispute, both sides can enter binding arbitration. While consumers can be wary of arbitration if it precludes their right to pursue litigation, securitization market participants tend to favor it.
"A lot of people like it because it could provide a more streamlined and quicker resolution than protracted litigation," said Eric Kaplan, managing partner, structured finance at Ranieri Strategies.
While Angel Oak's reps and warrants administrator falls short of the proactive "deal agent" that's been advocated for by investors, it is one of the steps the securitized private-label market has been taking in that direction.
"Only if the loan is in default will our responsibilities kick in, unlike a deal agent structure where you're monitoring many more aspects of the deal," said Jeff Tennyson, interim president at Clayton Holdings.
Angel Oak has so far decided against a deal agent because a deal agent's more extensive functions would add costs to the transaction and duplicate work already done by servicers and ratings agencies, said Hsu. Investors were pleased enough with its features to buy the bonds, he said.
